Rules for Home Office Depreciation for Businesses

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As I blogged earlier this week, I plan on taking the home office deduction this year against the income generated from my sole proprietorship. In addition to the home office deduction, I am qualified for the home office depreciation deduction as well (if you qualify for one, you qualify for the other) so I will also be taking that. While the rules for qualification are the same, the depreciation deduction is slightly more involved (since it’s not a simple summation of your expenses).

If you bought an office elsewhere for business purposes, you would be able to deduct the cost of that office across 39 years. With the home office depreciation deduction, you’re treating your home office as a purchase of that space and you can deduct that cost over 39 years. By definition, depreciation is “an allowance for the wear and tear of your home used for business” so it would not apply to the land the property sites on.

How Do You Calculate the Depreciation Deduction?
First, you must collect several important pieces of information:

  1. The month and year you started using your home for business purposes.
  2. Adjusted basis and fair market value of your home, minus the land, when you started using your home for business purposes. Adjusted basis is usually the cost of the home plus the cost of any permanent improvements minus losses or depreciation. Fair market value is how much money you could sell the property for, which can be determined from sales of similar property.
  3. Cost of improvements before and after you started using your home for business purposes. Here is a little bit of trickiness: work done on a home can be classified as a repair or as an improvement. Repairs are immediately deductible while improvements must be depreciated over 27.5 years. The difference is that if the work keeps the property stable and continually operating, it’s a repair. If it extends the life of the property or changes it significantly, it’s an improvement. Painting is a repair while installing a pool is an improvement.
  4. Percentage of your home that you use for business purposes. This is easy since you would use the same value as you would when figuring your home office deduction.

So for example, my house was appraised at $299,999 (I’m not sure if that’s the value I should use or if I should use the sale price of $295,000) and my home office is approximately 5% of the house (I’ll have to measure it to be sure), so I should be able to depreciate about $15,000 over 39 years. According to the MACRS Depreciation Tables from Publication 587 (I’ve referenced 2005 since the 2006 one hasn’t been released yet), since my business started in January 2006, I would be able to depreciate 2.461% of the $15,000, or $369.15. It’s not a lot of money, but it’s something.

Recapturing Depreciation
Since I will be depreciating the one room in my house, I’ll have to recapture it when I sell the house. You simply reduce the value of the home by some amount and you “pay” for the extra gain. For me this will be a non-issue, in terms of a net effect, because when you sell a house, you don’t have to pay up to $250,000 of the net gain if you buy another house. That limit increases to $500,000 for married couples (which I will likely be by then). So in terms of decision making, recapturing this depreciation is immaterial.

Whew! That was a lot of content and there is a good chance I got something in there wrong (maybe the math), so if you did wade through it (thank you!) please please please let me know if I messed something up!

{ 6 comments, please add your thoughts now! }

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6 Responses to “Rules for Home Office Depreciation for Businesses”

  1. James says:

    Maybe I’m misreading your article, but it sounds like you’re saying that the $500,000 primary residence exclusion will cover up all of the gain you’re likely to make on the house, even after adjusting the gain for depreciation. Is that what you’re saying?

    My understanding of the primary residence exclusion is that it doesn’t apply to gain from depreciation. If you take the home office deduction, then that $369.15 in depreciation will be considered taxable gain when you sell your house, even if your actual gain is far less than the exclusion limit of $500,000. Check out Publication 523. The non-numbered example on page 17 spells this out pretty clearly.

    Since you’ll be getting the tax benefit this year instead of when you sell the house, it’s kind of a wash, unless you’re in a different tax bracket when you sell. If that’s what you meant by “a non-issue, in terms of a net effect”, then my apologies for misunderstanding.

  2. 2 million says:

    Im no expert, but I thought you would be able to depreciate the structure on the 27.5 schedule (not 39yr) for the home office? Can someone confirm?

  3. CK says:

    If you are considering doing this please talk to a CPA. Remember with the IRS you’re guilty until proven innocent.

  4. ChrisCPA says:

    The depreciation taken on a home office is used to reduce the basis of your home – which, in turn, can increase your gain from the sale of the home, but this probably won’t effect most individuals – as their gain won’t reach the exclusion limits (250k, 500k). Also, a home office is depreciated over 39 years…Hope that helps!

    As CK said, it is a good to consult a professional before doing this.

  5. James says:

    The above comment from ChrisCPA is incorrect. The exclusion DOES NOT cover gain from depreciation. Here’s the relevant snippet from IRS Publication 523, page 17:

    Depreciation after May 6, 1997. If you were entitled to
    take depreciation deductions because you used your
    home for business purposes or as rental property, you
    cannot exclude the part of your gain equal to any deprecia-
    tion allowed or allowable as a deduction for periods after
    May 6, 1997. If you can show by adequate records or other
    evidence that the depreciation allowed was less than the
    amount allowable, the amount you cannot exclude is the
    amount allowed.

    When you sell your house, you will owe tax on the gain due to depreciation (unless your house actually went down in value).

  6. ChrisCPA says:

    My bad, James is exactly right, gain on the sale of a home is excludable from income to the limits, 250k & 500k, except the depreciation taken on the home office is recaptured & taxable…

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